For roughly 40 years while in the workforce, the retirement advice most people receive is the same: Accumulate, accumulate, accumulate. Save as much as possible, particularly in tax-advantaged accounts, such as 401(k)s, IRAs and Roths, as well as taxable brokerage accounts — because when you get to the end of your primary working years, you’re going to need to live on that money for the next two to three decades to come.
When retirement comes, maybe you have a party, but likely you wonder: How exactly am I going to do that?
The missing piece of advice is how to design a withdrawal strategy that not only lays out how much you can comfortably spend year to year but specifically, which accounts should you withdraw from when? Is there a particular order? Is there some secret formula?
“In general, people don’t think about this until it’s time to actually do it,” says Isabel Barrow, financial adviser with Edelman Financial Engines (EFE). Her colleague Andy Smith, an executive director with EFE (which, full disclosure, sponsors my HerMoney and Everyday Wealth podcasts), agrees. “You’re better off trying to get a few steps ahead and think about which accounts you’re going to draw from when before you get to that point.”
I had a chance to sit down with both of them together to talk through the important steps every retiree and soon-to-be retiree should take.
Here’s what they advise:
Step 1: Know the landscape
When it comes to taxes, there are three basic categories of accounts. Each has a distinct set of rules for putting money in and taking it out. You may already be familiar with these, but just in case:
- Taxable accounts: These are your basic brokerage accounts (also your Treasury Direct accounts for I bonds and savings bonds). You deposit money on which you’ve already paid income taxes. It grows, and you pay taxes on any realized gains each year. In taxable accounts, you can write off losses dollar for dollar against gains as well as against up to $3,000 in ordinary income. This is called tax-loss harvesting.
- Tax-deferred accounts: These are 401(k)s, 403(b)s, 457s, IRAs, SEP-IRAs and a few other accounts for the self-employed. You deposit pretax dollars. The money you invest grows without being taxed, and when you withdraw the money in retirement, you pay taxes at your current income tax rate. You can begin withdrawing money at age 59½ without penalty (before that, there’s typically a 10 percent penalty), and you must begin withdrawing at age 73 (currently) in the form of required minimum distributions (RMDs). The age by which you must start RMDs will climb to 75 in 2033.
- Tax-free accounts: These are your Roth IRAs and Roth 401(k)s. You deposit money on which you’ve already paid income taxes. The money grows tax-free. You never have to pull it out. In fact, you can pass it on to future generations tax-free, making this a valuable estate planning tool.